How Multifamily Real Estate Hedges Your Portfolio Against Market Volatility

Topic:  • By David Scherer • June 23, 2022 Views

For decades, stocks and bonds have worked in concert to balance investors’ portfolios: When one went up, the other went down, a dance that inspired the 60/40 portfolio. While it worked well for decades, it’s stumbling today. Rising interest rates and high inflation have led stocks and bonds to rise and fall in unison, diminishing returns. But multifamily real estate, one of the few asset classes to defy today’s brutal market volatility, offers investors a way to build and preserve wealth.

Investors who are skeptical of adding real estate to their 60/40 portfolio can look to the Yale University endowment, which continues to outperform its institutional peers, earning a 40.2% gain in fiscal 2021. The late David Swensen, Yale’s chief investment officer, diversified the Ivy League university’s holdings with longer-timeline alternatives, including private real estate. Under Swensen, Yale outperformed the 60/40 portfolio by 4.0% per annum.

Multifamily Real Estate Generates Stable Returns

Multifamily real estate has emerged as one of the strongest alternative assets. While restaurant, shopping and business travel waned in the U.S., multifamily housing attracted consistent demand over hotel, office and retail property and reached new record highs in 2021, Yardi Matrix data showed. Annual rent growth of 13.5% was more than double any previous year, and apartment absorption of nearly 600,000 units was roughly 50% more than the previous annual high set in 2015. While demand for business travel and commercial space waned in the pandemic, housing became critical as families sheltered in place.

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Overall, multifamily continued a more than 40-year pattern of generating the highest average returns among real estate asset classes in 2021—a trend that will likely continue for years to come due to low supply of rental units and homes for sale.

Uncertainty in equity markets is drawing investors to the stability of multifamily real estate. With inflation running at an 8.2% annual rate for April 2022, housing is holding its value as a hard asset. Investments in apartment buildings are essentially performing as a bundle of commodities—lumber, steel and other building materials. As construction costs increase, existing buildings get more expensive to replicate, and they grow in value.

Real Estate Assets Don’t Follow Stock Market Swings

As well, private multifamily real estate pays dividends to help stabilize the risk in a portfolio weighted toward volatile equities. Much like commodities, the value of multifamily real estate moves independently of stocks, bonds and even publicly traded REITs, which tend to follow the U.S. stock market. For example, when market conditions change, shares in REITs are bought and sold immediately, often based on investor sentiment, even as the dividend remains the same.

Multifamily rental income and asset leverage have the potential to boost results further. While public equity REIT dividends are below 3%, Origin’s dividends range from 5.5% to 6.5%. These fundamentals help portfolios with private multifamily real estate perform better. Modern portfolio theory holds that when trying to achieve portfolio diversification, seeking a low correlation with existing holdings can decrease portfolio risk without sacrificing return.

Returns Data Sources: NCREIF – Open End Diversified Core Fund Index – NFI-ODCE (Multifamily Real Estate), S&P 500 Total Return Index (Stocks), Barclays US Aggregate Total Return Bond Index (Bonds). Standard Deviation Data Source: Nuveen – Resiliency and Diversification From Uncorrelated Market Exposure Report – May 2021 (Stocks, Bonds and Private Real Estate)

Returns from 2000-21 suggest that a portfolio of 50% stocks, 30% bonds and 20% multifamily can produce risk adjusted returns superior to the classic 60/40 allocation. From 2000 to 2021, private multifamily assets produced a 11% annual return and a 19% higher Sharpe ratio—a widely used method to gauge risk-adjusted returns. Sharpe ratios above 1.0 are considered good as they are delivering excess returns relative to volatility; the one noted above is 1.44. In 2021 (below), annual returns in that portfolio rose to 18.5% with a  4.10 Sharpe ratio.

Returns Data Sources: Origin IncomePlus Fund (Multifamily Real Estate), S&P 500 Total Return Index (Stocks), Barclays US Aggregate Total Return Bond Index (Bonds). Standard Deviation Data Source: Nuveen – Resiliency and Diversification From Uncorrelated Market Exposure Report – May 2021 (Stocks, Bonds and Private Real Estate)

Demand and Cash Flow Buoy Multifamily Earnings

The U.S. economy contracted in 2022’s first quarter. Continued lower growth will make it increasingly difficult to generate stable income-driven returns and alpha through public markets alone. Low inventory and high demand have raised home prices and mortgage payments, which continue to rise compared to income and make home buying a less affordable option in many parts of the country.

That makes apartments a necessity for many, and it’s why multifamily housing will remain a good investment for the next few years. Average rents are up by double digits in rent.com’s trend report, with one-bedrooms up 26.5% and two-bedrooms up 25.7%. Shelter accounts for nearly one-third of the Consumer Price Index and has risen more than 5% year over year. Fortunately, rising wages will lower tenant resistance to future rent increases.

Despite inflation in the cost of building materials, multifamily valuations are still rising faster than construction costs. Development from the ground up remains profitable, often more so than value-add. A 50/30/20 portfolio, with a 20% allocation to real estate, provides opportunities to diversify in private equity or private debt, each of which offers different risk profiles, holding periods and tax treatments.

Nuveen recently identified private asset investments as a shield against volatility, with real estate as a long-term inflation hedge. Private real estate funds provide a stable, tax-advantaged alternative to counter stock and bond headwinds by diversifying from the classic 60/40 allocation. Allocating investment assets to real estate will continue to be a solid defensive move that provides passive income with the prospect of long-term gains.

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Posted By

David Scherer
Co-CEO

David Scherer formed Origin Investments in 2007, along with Co-CEO Michael Episcope. He has more than 25 years of experience in real estate investing, finance and asset management.